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Time for ECB to Make Another U-Turn

By

Simon Nixon

Updated Nov. 27, 2010 12:01 a.m. ET

The European Central Bank doesn't carry primary responsibility for the latest euro crisis, but it has played its part.

Its increasingly hawkish words and deeds have helped pile pressure on peripheral European countries and their fragile banking systems. Whether this is unintentional, or an attempt to force fiscal authorities to face their own responsibilities, isn't clear. But it is clear the ECB should be prepared to reverse course quickly to save the euro.

ECB officials have made little secret of their frustration at the lack of urgency from euro-zone governments and banks to repair their balance sheets. Many banks have relied on ECB financing for much of the last three years, refusing to raise the necessary capital to entice markets to resume lending. As a result, the ECB has crossed the line from providing emergency liquidity to effectively funding regular lending, which runs contrary to all central-bank orthodoxy. Its lending to Irish banks now totals more than 80% of the country's gross domestic product.

The ECB has been trying to exit from this emergency support all year. Although it has continued providing unlimited liquidity in three-month tender offers, it stopped offering 12-month tenders in March. It closed its covered-bond-buying program after June, which Morgan Stanley argues undermined support from a key source of funding for peripheral banks. And, in contrast to the aggressive Federal Reserve, the ECB has bought just €66 billion ($88 billion) of government bonds. The market is now waiting anxiously to see whether it will switch the three-month tender offers from fixed to variable rates next year.

But the crisis has exposed the limitations to the ECB's orthodoxy. It is the only European institution able to make quick decisions on behalf of the whole currency bloc. This week's political wrangles over conditions to attach to the Irish rescue deal, whether to increase the size of the existing bailout funds, and the terms of any future permanent crisis-resolution mechanism have shown that Europe's fiscal authorities cannot move fast enough. If the contagion spreads, as seems likely, the ECB will need to act to maintain financial stability, in line with its mandate.

That will involve some unpalatable decisions. Clearly, it must abandon plans to tighten conditions for its three-month tenders in the New Year. It also must be prepared to buy large amounts of government bonds. That will, of course, be anathema to Bundesbank inflation hawks, concerned already at evidence the German economy is close to full capacity.

But faced with a life-or-death struggle for the survival of the euro zone, those concerns no longer count for much.